Changing practices and cost-cutting measures in the banking sector have not yet been priced into the...
Changing practices and cost-cutting measures in the banking sector have not yet been priced into the market, creating opportunities for fund managers.
The refocusing of high street banks' lending activities to target higher margin, longer-term consumer business and move away from higher risk, lower margin, large-cap corporate lending is enabling the sector to improve profitability despite poor market conditions.
Lance Phillips, an investment director at Standard Life Investments, says: 'The fact long-term interest rates are higher than short-term rates has made lending to consumers much more attractive. This is because mortgages are priced at the long end of the yield curve, while the banks can borrow cheaply at the short end.'
This refocus has also seen a number of banks favouring the offering of credit to smaller companies as the business is not only higher margin, the potential default is also lower. Use of securitisation techniques is also lowering the sector's risk profile,
Phillips adds. 'Banks have made use of the capital markets to increase their throughput of lending transactions and so generate more fee income. They have packaged portfolios of loans into asset-backed securities that are sold to other financial companies.
'The sale provides the cash for the lending banks to recycle into another round of mortgages and loans. The buyer accepts the risks and rewards of the loan portfolio.'
While Phillips believes much of the banks' streamlining of their practices has not been priced into the market, those predominantly reliant on mortgage business are now looking fully valued at best.
Mortgage banks have understandably had a strong run on the back of interest rates falling to a 38-year low and mortgage lending reaching a new record high in July.
Richard Peirson, manager of the Framlington Financial fund, is repositioning his portfolio away from mortgage banks, taking profits and buying into more high street names.
'Our Financial fund has remained underweight investment banks and overweight retail banks. This has resulted in a structural overweight position in the UK market, which has a greater proportion of pure retail banks than other markets,' Peirson says.
'We have preferred mortgage banks over the major high street names but have started to reverse that position, selling Bradford & Bingley and Alliance & Leicester in favour of Royal Bank of Scotland and Barclays, which we believe look better value.'
The main threat to the overall banking sector, Phillips says, is the possibility of interest rate rises, which will slow the property and consumer credit markets. Banks will then have the option of either accepting lower margins or fees to maintain existing growth rates or settling for slower growth with higher returns, he notes.
The truth probably lies somewhere in between, although experience gained from recent corporate blow-ups should see banks better able to avoid and/or manage defaults.
In the near term, Peirson is confident high street banks are on attractive valuations and will be a strong driver of domestic recovery.
Strong YTD for mortgage banks.
High street banks on attractive valuations.
Rise in diversification of banks' business.
Mortgage banks look fully priced at best.
Risk of defaults remains very real.
Consumer credit market expected to slow.
Two global vehicles
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